Financial Crisis – January 2011 Headline

Based on developments in the financial markets and the lack of significant regulatory reform, following is a potential headline news story from the future.

AIG and several major investment banks are on the verge of collapse and have returned to the Fed requesting assistance to prevent a collapse of the US financial system. In late 2008 and 2009, the world financial system almost failed due to failed investments in the housing market. The Fed at that time pumped trillions of dollars of liquidity into the system which resulted in the Fed owning a large part of the major investment banks and AIG and the Fed also lowered interest rates to almost zero to assist the banks in re-capitalizing. Because of the low rates of returns available at that time on CD’s and government bonds, and the low interest rates charged on loans, investors borrowed hundreds of billions of dollars which were invested in corporate bond funds and purchased Credit Default Swaps (CDS) on 80% of bond purchases. With corporate bankruptcies having increased by 20% in 2010, a large percentage of the underlying bonds have defaulted and the investors are demanding that AIG and the investment banks honor their CDS obligations. AIG and the investment banks under-priced the insurance sold but the sale of the insurance significantly increased their 2009 and 2010 earnings. Although only $600 billion in bonds have defaulted, over $2 trillion in CDS insurance was purchased on the defaulted bonds. The 5 largest investment banks and AIG are requesting $1.5 trillion of capital which is required to cover the CDS obligations.